Friday, March 11, 2005

401K Plans Explained

I'm always amazed at how little I know. I'm really very dumb. I try to learn stuff but it seems that I can't keep up. I'm always behind. I'm always out-smarted. I think I'm synapsis-challenged.

I give details below but here's the basics.

All 401K plans are not the same. It varies from company to company. If you work in the tech sector and work for a software house, odds are you can contribute the maximum for your tax bracket under IRS law. If you work for a company that has a lot of low-paid employees, you can't contribute as much. The reason? IRS says that in order to avoid discrimination a company must have an equal distribution of highly compensated employees and non-highly compensated employees contributing to a company sponsored 401K. Actually it's a complex test and audit they do but I'm trying to make this simple. (IRS calls highly compensated employees HCEs. I'm not making this up!)

As I stated before, if you work in a software house, odds are everyone is making about the same. If you work for a company that has a high percentage of low pay employees, say $7/hr you'll have a problem maxing out your pre-tax 401K plan.

This is something no one told me. I couldn't figure out why my desired 15% payment into my 401K plan wasn't adding up in my check stubs. I did some calculations and discovered the 5% ceiling. I called my Benefits folks and they tried to explain this to me. It wasn't until I spoke to three people and read numerous pages on the Internet that I finally understood. It's a crazy world out here.

Now here's the really goofy part. If you happen to be a VP the company can do what they euphemistically call "make you whole." Yeah, it's kind of creepy sounding I know. Here's how it works: Say that you want to contribute 15% but the company's 401K plan doesn't allow more then 5%. The company will "make you whole" by setting aside some cash that they give to you as a bonus for the dollars you would have lost. Nice. As you know, VPs who make $500k a year need this "benefit." I mean, just think of what their gross would be without this little offset.

The reason why most folks never see this is because usually companies don't allow you to contribute to a 401K the first year of employment. When I worked for my previous software company we made good money on the 401K. The company was even matching for a while. Now it's a joke.

So the next time you negotiate a deal with a company, find out what their HCE vs non-HCE mix is, or just ask what the current ceiling is for HCEs. That'll tell you a lot and can help you negotiate a better deal if you are an HCE.

You can read more about the IRS law and company sponsored 401K here.

You can read about upcoming changes and options here.

...dave x84038 Architect for The Home Depot
It takes a lot longer to say what you think than tell what you know.